Are you an investor looking for ways to measure how profitable a company is? Well, ROCE and ROE are two crucial financial metrics that are used to know the profitability of companies.
ROCE gauges how well a business uses all of its capital to create more profits, while ROE measures how much profit a business makes for just its shareholders.
In this article, we shall take a look at ROCE and ROE, how they measure a company’s performance in terms of profitability, how they differ from each other and when they should be used. Keep reading to find out!
What is ROCE?
Meaning of ROCE
Return on Capital Employed, or ROCE is a financial ratio that is used to assess a company’s profitability and capital efficiency. It is especially useful when comparing businesses in capital-intensive industries such as oil and gas, telecommunication, and iron and steel.
Ideal ROCE
A high ROCE indicates that a larger chunk of the company’s profits can be invested back into it for the benefit of shareholders. Therefore, their capital will be reinvested at a higher rate of return. Generally, investors consider an ROCE of anything above 25% as good.
ROCE Formula
ROCE= EBIT/Capital Employed,
Where,
EBIT = Earnings Before Interest and Tax
Capital Employed = Total Assets – Current Liabilities
How does ROCE work?
- ROCE indicates a company’s profitability after considering the capital used to achieve that profitability.
- It is particularly effective when comparing companies in capital-intensive industries, such as oil and gas companies.
- A higher ROCE indicates stronger profitability across company comparisons.
- Apple-to-apple comparison is encouraged when using ROCE to analyze stocks. Each industry has different characteristics that will alter their profits and use of financing, therefore it is important to compare companies in the same industry.
What is ROE?
Meaning of ROE
Return on Equity (ROE) is a financial ratio that is used to assess how profitable and effective an organization is at generating profit from equity investment. It is an important metric for equity investors as it reflects the company’s ability to generate returns on their investment.
Ideal ROE
A high ROE indicates that a company’s management is efficient at generating income and growth from its equity financing. Generally, investors consider an ROE of 15% to 20% as ideal and anything above 20% as good.
ROE Formula
ROE = Net Income / Shareholders’ Equity
Where,
Net Income = Total Revenue – Total Expenses
Shareholders’ Equity = Total Assets – Total Liabilities
How does ROE work?
- ROE is expressed as a percentage and can be calculated for any company if net income and equity are both positive numbers.
- Apple-to-apple comparison is encouraged when using ROE to analyze stocks. Each industry has different characteristics that will alter their profits and use of financing, therefore it is important to compare companies in the same industry.
- The formula for ROE is net income divided by shareholders’ equity. Net income is calculated before dividends are paid to common shareholders and after dividends to preferred shareholders and interest to lenders
- A high ROE indicates that a company is efficient at generating profits from its equity financing.
When should you use ROCE and ROE?
Both ROCE and ROE are important financial ratios. They measure different aspects of a company’s financial performance. Usually investors use these ratios together to produce a complete picture of a company’s financial performance..
When to use ROCE:
- ROCE is a better measure of a company’s overall efficiency in generating profits from all available capital, as it includes debt and equity.
- It is particularly useful while comparing companies in capital-intensive industries.
- ROCE is a useful management tool for assessing the performance of different business units or projects within a company.
When to use ROE:
- ROE is a better measure of a company’s profitability from shareholders’ equity
- It is a useful management tool for assessing the performance of a company’s equity financing.
- ROE is particularly useful for evaluating investment returns of a company within a particular industry
Difference between ROCE and ROE
| Parameter | ROCE | ROE |
| Definition | Measures how efficiently a company utilizes all available capital to generate additional profits | Measures how effectively a company uses shareholders’ equity to make a profit |
| Formula | EBIT / Capital Employed | Net Income / Shareholders’ Equity |
| Capital Considered | Considers both debt and equity | Focused solely on equity |
| Purpose | Indicates a company’s ability to generate returns on invested capital | Evaluates a company’s ability to generate returns from its equity financing |
| Industry Comparison | Useful for comparing companies in capital-intensive industries | Useful for evaluating investment returns of a company within a particular industry |
In Closing
Both of these ratios have their own advantages and disadvantages. However, it is important to use both of them together to get a complete picture of a company’s performance.
While ROCE is a better measure of a company’s overall efficiency in generating profits from all available capital, including debt and equity, ROE is a better measure of a company’s profitability from shareholders’ equity.
FAQs
ROCE or Return on Capital Employed is a financial ratio that measures a company’s efficiency in generating profits from all available capital, including debt and equity.
ROE or Return on Equity is a financial ratio that measures a company’s profitability by dividing its net income by shareholders’ equity.
ROCE considers both debt and equity financing, while ROE is focused solely on equity. ROCE is a better measure of a company’s overall efficiency in generating profits from all available capital, including debt and equity, while ROE is a better measure of a company’s profitability from shareholders’ equity.
ROCE is useful for comparing companies in capital-intensive industries. Moreover, it is a good indicator of a company’s ability to generate returns on invested capital.
ROE is useful for evaluating investment returns of a company within a particular industry. It is a good indicator of a company’s ability to generate returns for its shareholders.
Both ROCE and ROE should be used together to evaluate a company’s financial performance. If other metrics are good, a company with a high ROE and a high ROCE is considered to be a good investment because it generates high returns on both equity and capital employed.
